Gearing up for Growth

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At the peak of the market pre-GFC, RBA data reveals Australian investors held over $40 billion in margin loans – at the end of 2016, despite several years of bull market, margin loans were just one quarter of that figure at circa ~$10 billion. A lot of fingers were burnt in 2008 – margin calls peaked in December that year, with 8.6 calls per day per 1,000 investors. That’s a lot of pain.

However, times change and bull markets return – and so too the opportunities to make money from gearing.

What is margin lending – and why do it?

A margin loan is a form of gearing. An investor borrows money to invest in approved shares, exchange traded products (ETPs) or managed funds. That investor’s cash or investments are used as security for the loan.

Each different lender has a list of approved securities, which will specify the percentage of the value of each investment that can be used as security – the loan to value ratio (LVR). The investor must provide cash or other securities to bridge the difference between this lending value and the total loan.

For example, a margin lender has an LVR of 70% on Telstra (TLS). An investor wishes to purchase $10,000 of TLS shares; the margin lender will provide $7,000 (70% of the total) and the investor must provide $3,000 in cash or other securities.

The why is simple – borrowing to invest increases the number and quantum of assets that can be purchased. Even though the volume of money in margin loans is lower today than previous market highs, there’s currently more than $10 billion in margin loans helping investors to:

Diversify – more money to spend means a greater spread of investments; when that portfolio is geared, diversification can reduce the risk that poor returns from one investment will reduce the value of the total portfolio.

Unlock equity – investors can borrow against existing assets to expand their investment portfolio; no selling one asset to buy another. This has the added benefit of not triggering a potential capital gains tax liability.

Increase investment returns – as illustrated in the following example, gearing magnifies gains (and losses – we’ll get to those)

Compare the pair: two portfolios – one geared, one not. Both started with $20,000 – portfolio one added a margin loan of $40,000.

If the value of the investments in the portfolio increased 10%, the impact would be a 30% increase in value of the geared portfolio.

Portfolio one: with a margin loan

Portfolio two: without a margin loan

Market value of investments

$66,000

$22,000

Remaining capital after loan paid

$26,000

$22,000

Gain

$6000

$2000

Gain as % of funds invested

30%

10%

Source: Leveraged Equities Limited

Increase income – investors can buy high yielding securities and get more dividends from the portfolio because they own a greater number of securities

Improve after-tax returns – with margin loans, there is the prospect of tax benefits, although that varies with each individual. Such benefits might include:

a tax deduction for interest payments on the margin loan

buying a greater number of securities with fully franked dividends

negative gearing if the expenses associated with the margin loan are greater than the income received.

What about the risks?

I think it’s fair to surmise that many investors got their fingers burnt using a gearing strategy in the run up to the GFC. When markets fall quickly, it can be hard to unwind a strategy quickly enough to avoid losses. And while gearing can amplify gains, it can also magnify losses and trigger the dreaded margin call.

Using the same pair of portfolios, let’s examine the impact of a 10% loss. In the same way portfolio one gained 30% through gearing, so too the loss is amplified in the geared portfolio.

Portfolio one: with a margin loan

Portfolio two: without a margin loan

Market value of investments

$54,000

$18,000

Remaining capital after loan paid

$14,000

$18,000

Loss

-$6,000

-$2,000

Loss as % of funds invested

30%

10%

Source: Leveraged Equities Limited

Margin calls

It’s the call no investor wants – a demand for funds, pronto. In a situation where an investment portfolio becomes worth less than the margin loan, a margin call will result. It can be rectified by the addition of money or securities to the account; however in the case of a prolonged bear market, the margin call might not be a one off.

When an investor borrows to invest, the margin lender takes security over the investments bought with that loan. These investments can be sold by the lender to repay the loan if the investor is unable add cash or other securities to the portfolio. If the value falls significantly, the investor might lose the assets and still be in debt to the lender…and experience tremors every time the phone rings.

What are investors buying with their margin loans?

The Investment Trends 2016 Margin Lending Investor Report is an in-depth study of the attitudes and behaviours of Australia’s margin lending users. Based on a survey of 1,418 investors, it found that while the industry had contracted, the number of investors using margin lending fell at the slowest annual rate since the GFC.

The survey also showed that Leveraged continued to be the industry’s highest rated margin lender (in 2016, a joint award with CommSec) …so I put the question to Leveraged: where are their clients investing the proceeds of margin loans?

In summary:

Approved ASX-listed shares make up almost 90% of securities held by existing Leveraged margin lending clients

Demand from clients for exposure to the ETF market has increased by nearly 300% over the past five years

Demand for managed funds has remained largely static over the past five years.

The top ten ASX-listed stocks held by existing margin lending clients:

Commonwealth Bank

Westpac

National Australia Bank

ANZ Banking Group

BHP

Telstra

Wesfarmers

Macquarie CPS Trust

CSL Limited

Woolworths

Source: Leveraged Equities Limited

The top ten ETFs held by existing margin lending clients:

SPDR S&P/ASX 200 Fund

BetaShares Australian Dividend Harvester Fund

iShares S&P 500 Index ETF

iShares Global 100 ETF

BetaShares Yield Maximizer Fund‎

Vanguard Australian Shares Index ETF

iShares S&P/ASX 20 ETF

iShares Global Healthcare ETF

Vanguard Australian Shares High Yield ETF

BetaShares U.S Dollar ETF

Source: Leveraged Equities Limited

It seems most investors using margin loans are managing the risks associated with gearing portfolios by investing in well capitalised stocks (many of which are known for generous dividends) and ETFs largely based on major indices. It’s hard to know whether that’s enough to protect a geared portfolio in a market downturn…but who knows, this market could run and run, and phones remain a source of business and entertainment, not the harbinger of doom.

Tracey Franks is one of OpenMarkets' regular blog contributors and content writers, who has worked in financial services for over 20 years in businesses spanning stockbroking, funds management, research and consulting, as well as financial planning. When not writing about finance-related topics, Tracey is working on her first novel.